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ETFs: Exchange traded funds made easy
By Gene Walden
From the Minneapolis StarTribune

If you’re looking for a quick, cheap, easy way to buy a stake in the stock market, you might consider “exchange-traded funds” (ETF). ETFs are similar to mutual funds in that they give small investors the ability to buy a diversified basket of stocks with a single purchase. But they also feature some important benefits that traditional mutual funds don’t offer.

Most ETFs hold a broad portfolio of stocks that mirrors a stock index, such as the Dow Jones Industrial Average, the Russell 2000 or the Standard & Poor’s 500. “You can also find ETFs for almost every sector, as well as international funds and single country funds.” explains Mike Rogers of 360 Financial in Minnetonka. “We use them to build a diversified portfolio for our clients.”

ETFs are not only becoming a popular option for money managers, their unique benefits have also caught the attention of small do-it-yourself investors. ETFs enable you to start small—there is no minimum—get instant diversification, and build your portfolio from the ground up.

ETFs trade like stocks on the major stock exchanges, including the New York Stock Exchange, the American Stock Exchange, and the NASDAQ. You can buy ETFs through any broker or online brokerage service.

ETFs have no front-end or back-end loads, but you would pay a brokerage commission to buy shares of ETFs—just as you would with any other stock. Their annual fees tend to be significantly lower than most mutual funds.

“Since most ETFs are tied to a stock index, they require less management and fewer trades, so their management fees tend to be very low,” says Rogers. “Annual management fees tend to vary from as low as 0.1 percent of assets under management to 0.75 percent.”

By contrast, mutual funds charge an annual expense ratio that typically ranges from just under 1 percent to over 2 percent, and many funds have additional hidden fees that cover trading costs and other management expenses. Many fund families also charge sales loads that typically range from 4 to 6 percent.

Barclays Global Investor is the leading provider of EFTs. The firm offers well over 100 portfolios, which it terms “iShares.” State Street Global Advisors offers ETFs under the name “streetTracks,” and Vanguard and PowerShares also offer a wide range of EFTs. Merrill Lynch is one of a growing number of other investment firms that are venturing into the ETF market.

That trend toward ETFs should continue, considering the advantages they offer over mutual funds. In addition to lower costs, ETFs provide:

More flexibility. If you want to sell shares of a mutual fund, you can’t unload them until trading closes at the end of the day. With ETFs, you can buy or sell shares at any time during the day. “Let’s say the market is up 100 points, and you want to take your profits and get out of the market before it closes,” says Rogers. “With an ETF, you can sell at any time and take your profit. But with a mutual fund, you can put in an order to sell any time during the day, but your shares won’t be sold until after the market closes. If the market drops in the final hours before closing, you’ll miss out on those gains in your mutual fund.”

Limit orders. You can buy or sell ETF shares through a limit order—just as you can with any stock—but you can’t buy and sell mutual fund shares through a limit order. A limit order is an order to buy or sell a security at a specified price. For instance, let’s say you want to buy an ETF at a price $3 below its current trading price (or you want to sell your shares at a price $3 higher than its current trading price). You set the price—your limit—put in the order to buy or sell the ETF and if the market reaches your target price, the trade will automatically be executed.

Tax benefits. ETF owners get a fairer shake on their taxes than mutual fund investors for a couple of reasons. ETF managers make very few trades because their portfolios are generally tied to a stock index, while most mutual fund managers actively manage their portfolios, creating more trades and more taxable events.

ETF investors are not subject to the same embedded tax liabilities that mutual fund investors may face. Mutual funds pay out all capital gains annually, creating a tax liability for everyone who holds shares of the fund—even investors who buy shares near the end of the year. ETF investors, on the other hand, are not liable for capital gains generated prior to their investment.

For investors who want the diversification of mutual funds with lower fees, more flexibility and better tax benefits, ETFs offer a compelling alternative.



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